By Jake Fuss and Alex Whalen
The recession caused by the response to the COVID-19 pandemic means governments across Canada now face tremendous fiscal challenges. Recent forecasts from the Royal Bank and Parliamentary Budget Officer (PBO) estimate that annual deficits in 2020/21 could total more than $300 billion between the federal and provincial governments. As a result, Canadian governments must develop credible plans, once this crisis passes, to return to balanced budgets.
The Royal Bank forecasts that all 10 provinces will run deficits this year due to declining revenues and new spending. However, provinces with an abundance of natural resources will be the hardest hit. Alberta could see a deficit of $18.0 billion (6.4 per cent of GDP) and Newfoundland and Labrador’s deficit could total $2.0 billion (7.0 per cent of GDP) this year. On aggregate, the Royal Bank predicts that provincial government deficits will reach nearly $63.0 billion.
Similarly, the PBO projects a gloomy scenario for the federal government—the national economy will contract by 12.0 per cent this year and the federal deficit will reach $252.1 billion in 2020/21 (12.7 per cent of GDP). Moreover, federal debt could approach $1 trillion by the end of the fiscal year. The graph below summarizes the deficit projections (as a share of the economy) for the provinces and federal government.
These projections underscore the worrying state of provincial and federal finances. Why do large deficits and more debt matter? Because governments pay interest on debt just like households must pay interest on mortgages, car loans and credit cards. The additional money spent on interest leaves fewer resources for tax relief or government programs such as health care, education and social services.
Ultimately, government debt will not only burden current taxpayers, but future generations of Canadians who will repay the debt and cover the interest payments through higher taxes and/or lower comparative government spending. And these higher-than-anticipated taxes will impede future economic growth and prosperity.
Significant research has examined the best way for governments to move towards budget balance following a recession. Harvard economist Alberto Alesina and his colleagues, in particular, have studied government responses to large deficits linked with recessions. In general, governments face a choice between increasing taxes and cutting spending to balance their budgets.
Alesina’s work finds that reducing government spending is a less-damaging response to controlling deficits compared to tax increases. In fact, Alesina has examined many historical examples of how countries similar to Canada chose to rein in deficits. The experience of these countries, as shown in his research, demonstrates that reductions in government spending are clearly the better course of action.
On the other hand, government spending cuts have been shown not only to be less-economically damaging, but can actually enhance economic growth. Private investment tends to rise when government spending is reduced, which assists the recovery. Of course, these are exactly the types of choices the federal government and provinces must make. Indeed, Alesina specifically noted the experience of Canada in the mid-1990s when the federal and some provincial governments reduced government spending, markedly in some cases, while simultaneously experiencing improved economic growth.
To be clear, many of the fiscal responses to the current downturn have been necessary to ensure some level of income stability for Canadians. However, federal and provincial government deficits are expected to surpass $300 billion this year, with subsequently high deficits next year, leading to marked increases in debt. Over the coming months, as the discussion turns from crisis to recovery, governments will face choices about how to handle these historic deficits and return to balanced budgets. The economic research is clear—reining in the size and cost of government is the best policy.